How often do Vanguard Target Date Funds rebalance?

I’ve been doing a lot of research lately on portfolio rebalancing and it got me wondering about Vanguard’s rebalancing strategy for its own target date funds.  After reviewing the fund’s prospectus, I decided to give Vanguard a call directly using their customer service line and ended up speaking with a representative named Robert.  I asked Robert two primary questions:

How often does my target date fund (VFIFX) rebalance?  Robert first searched through the prospectus and couldn’t find anything there so he had to place me on hold and speak with another department.  When he came back he told me that Vanguard rebalances daily just by properly managing the money coming into the fund from new investors/re-investors and the money going out of the fund from withdrawals.  He also told me that if the portfolio skews more than 2 or 3 percent from its target allocation, the fund will actively buy or sell shares of its underlying holdings to rebalance.  I pressed Robert on this point by asking him if it was an automatic 2% trigger or if the fund would only make an active adjustment during set time periods.  In other words, did the manager check the fund every quarter and only rebalance if the assets were more than 2% off, or would the manager rebalance any time the the assets were 2% off – even if it meant making trades every other day (like in a volatile market)?

Robert’s response to this was interesting – although in retrospect unsurprising.  He said that Vanguard does not release that information because of the potential for abuse.  If it was public knowledge that Vanguard rebalanced its funds on certain dates, then traders could take advantage of that fact by manipulating the price of the underlying funds that the VFIFX would have to buy in order to rebalance (In this case, VFIFX has 3 underlying funds: the Vanguard total stock market index, the Vanguard total international stock market index, and the Vanguard total bond index).  I’m not entirely sure how someone could benefit from this knowledge, but I’m guessing it is related to the ways in which a hedge fund manager can manipulate stock prices.

Does my target date fund shift its asset allocation on a continuous basis?  Robert pointed me to the graphic on the Vanguard Target Retirement fund site (which I’ve also linked to in previous posts).  When you click on a fund under the heading  “Decide which fund is right for you,” you will see a graphic similar to the one below.  This particular graphic corresponds to the 2050 fund (VFIFX).

As you move the slider left or right, it will tell you the asset mix that the fund will have at that time.  My question to Robert was whether the asset allocation changed continuously as the graph indicates (meaning a smooth line), or if it changed at stepped intervals – like every five years that corresponds to the Target fund offerings (there is no target date fund for 2051).  Robert said that the graphic essentially represented how the allocations would change, but didn’t go into much further detail.

I took a screenshot below showing the allocation change that occurred by moving the slider slightly to the right.  From what the graph tells me (by playing with the slider for a few minutes) the asset allocation changes every year. Presumably that is the answer – Vanguard Target Date Funds adjust their allocation every year.  Although, conceivably Vanguard could adjust the allocation daily by hundredths of a percent to create an even more continuous risk reduction instead of adjusting just once a year.

What percent of my income should I save for retirement?

I recently got an email from our HR department at work saying that I should be saving for retirement (Thanks guys!).  The email included a nice little graphic which seemed to suggest that I should save 6% of my salary.  Based on the assumptions (annual return of 7%), if I am 30, earn 40,000 a year and put 6% away for 30 years I will have $234,860 (in today’s dollars).  If I retire at 60, and expect to live until 80, that means I’ll have about $17,400 to live on per year in retirement.  (Its more than $11,700 (234,000/20 years) because I earn interest on the money that I haven’t taken out yet).  Either way, 17,400 isn’t much – especially considering the fact that I plan on living past 80 and $17,400 is less than half of the salary I would be used to.  Clearly 6% is not enough.

How much is enough? If 6% is not enough, then what is?  This is such an important question because it should be the foundation of your monthly budget.  If you are trying to do things right, you set aside money for your retirement first, and then see how much you have left to spend on everything else.  Again, its that old expression, “pay yourself first.”  So, what is a good percentage of gross income that you should be saving?  The typical rule of thumb is that you should save 10% of your salary for retirement.  But as the linked article suggests, even 10% may not be enough.  You may be 42 years old with no money saved for retirement (you’ll need to save much more than 10% of your income) or 25 and trying to retire early.  So while 10% of your income seemed like a good place to start as a minimum, it was clear to me that I needed to do some extra research to come up with a percentage that was more than just a rule of thumb.

I started playing with the zillions of online retirement calculators out there (just google “retirement calculator”) and quickly realized that “annual savings as a percentage of income” was just one of many variables in their complex retirement equations.  Fortunately,  Vanguard’s retirement calculator was simple enough to allow me to easily isolate the “savings as percentage of income” variable.   Even with its simplicity, however, the Vanguard calculator still required me to make some assumptions about retirement.  I’ve included a screenshot of what they look like in the Vanguard calculator as well as an explanation of my assumptions below.  In general, the assumptions are set for the average 25 year old who is thinking about retirement for the first time.

  1. How old are you and when will you retire?  25, 65.  Unless you have visions of jet-setting at age 50, the standard answer is age 65.  I can see the argument to use age 70 since we will probably be living longer than the current generation and social security benefits might not start until 70 when we are in the year 2050. It is much easier, however, to plan to retire at 65 and later decide to work until 70 than it is the other way around.
  2. What is your current annual income? $50,000.    This number is only relevant because it is used to determine the actual dollar value of how much money you will spend per year in retirement.  According to Vanguard (and most other retirement calculators), the typical retiree spends 85% of his pre-retirement  annual gross income in a year.  The blue bar in the chart at the right displays the result of this calculation; ($50,000 * 85% / 12 months = $3,542 a month).
  3. How much do you save annually for retirement?  To be determined.  This is the variable that we are trying to figure out, with the focus on the percentage of annual income and not the actual dollar value.  Note that it should include your personal contributions to an IRA, as well as any work contributions (including employer matching) in 401(k)s and 403(b)s.
  4. How much have you already saved for retirement?  $0.00.  I am assuming that you are just starting out.  If you have some money already saved, I encourage you to input all your information into calculator to get a personalized look at your retirement plan.
  5. What’s your market risk approach (In other words what will the average annual return of your investments be)?  Somewhere between 4% and 8%.  Part of this will be determined by the investments you select.  If you have a more conservative portfolio with a heavy percentage of bonds you can generally expect a lesser return than a more aggressive portfolio consisting mostly of stocks.  But even if I assumed that everyone had the same retirement portfolio, I still can’t predict how it would perform over the next 30 years. In the past your investments may have made 7% a year, but what if over the next 30 years it only averages 6%?  Click here for a great graphic from the New York Times that depicts the variability in 20 year returns.
  6. Will you receive any money from social security or pension? Maybe… If you are lucky enough to be in a profession that still distributes pensions, then great, you can include that income here.  Most of the private industry jobs out there now, however, do not distribute pensions, so the standard answer is $0 from pensions.  Whether or not you will receive any money from social security, however, is the bigger question.  There are countless articles out there detailing the unsustainable state that the social security system is in.  This article was the best I’ve found explaining the situation, and even offers some actionable advice.  If no policy changes are made, social security benefits will eventually have to be cut by one third.
  7. How long will you live in retirement?  Doesn’t matter.  This is not explicitly asked on the Vanguard calculator, but it is used in the behind the scene calculations.  Some retirement calculators use an equation that ensures you spend all your retirement money by age 85 (the standard guess for how long you will live).  Vanguard however uses the 4% rule.  The idea is that once you are in retirement, your nest egg will be put into more conservative investments where 4% is a typical return.  If you only take out 4% of your nest egg every year to live on, then that 4% will be replenished by investment gains and your nest egg will never lose value.  By using the 4% rule, you reduce the risk that you will run out of money if you live longer than you expect.  The “downside” is that when you die you might not have used all of your money up.  By using the Vanguard calculator and its 4% rule, the amount of money they recommend you save for retirement may be higher than the other calculators, but I think it is a much smarter approach than trying to guess how long you’ll live.

How can I plan for retirement if I can’t predict my rate of return or if Social Security will exist?  You’ll notice that I have answers for all of Vanguard’s questions except for two: “Will I receive money from Social Security?” and “What will my average annual rate of return for my investments be?”  Without knowing the answers to these two questions it is impossible to come up with an educated guess on what percent of my gross income I should be saving for retirement.  Because I don’t have a crystal ball, I settled for the next best thing – a spreadsheet that lets me test different scenarios.

In the interest of full disclosure, you should know that this spreadsheet is simply a recording of the values taken from Vanguard’s retirement calculator.  So for example, to get the 10% value at the bottom right of the chart, I set the “market risk approach” slider to 9.5% , set my social security benefit to $833 a month (20% of $50,000 / 12 months), and then adjusted the “how much do you save annually” slider until the green bar was equal to the blue bar.

So what does it all mean? First of all, saving 10% of you gross income is not nearly enough.  The only way that would work is if you received a significant amount of social security benefits, and your retirement portfolio earned a ridiculous 9.5% return per year.  Personally, counting on a 6% – 7% return seems much safer to me.  If you read my post on target date funds, you know that the investment style starts out very aggressive (90% in stocks) and gets more conservative as you get closer to retirement (65% stocks with 10 years to go).   So even though I have an “aggressive” portfolio, I’m still not counting on getting any returns out of the ordinary.

What percent of my income should I save for retirement? So here we are, finally back to the original question.  The answer is about 20%. If you are expecting a 7% return on your investments (a reasonable/slightly conservative guess) then you’ll need to save between 17% and 22% of your gross income every year – depending on how much social security you expect.  If you are making $50,000 a year and retired today, you could expect to receive social security benefits that would cover 37% of your current income.  As noted above, however, it is highly unlikely that social security will be around in the same form when you retire.  If it is still around, a safe bet is that you can expect to get 1/3 of the benefits you would receive today.  In other words, you could expect social security to cover 12% of your current income.  If thats the case, you would need to be saving about 20% of your annual income per year.

I guess what I’m saying is that 20% should be the new rule of thumb.  Now, I’ll be amazed if any of my friends saves anywhere near this amount.  I mean, lets face it, 20% is a lot of money.    But that is the reality these days; because unlike our parents, we can’t rely on pensions or social security or even a US economy that is growing like crazy.  Obviously, it would be great if the market continues to grow and all of the asumptions prove too conservative.  And if thats the case then that means you can travel to your hearts desire or even leave a little extra to your kids.  I don’t see a downside there.  But if you only save 10%?  Anything other than great returns and lots of social security means you wont have enough to retire.  Its a tough pill to swallow – having to save 20% of your income – but it is the only way that the numbers work.  Its honestly kind of hard to believe that the advice I was given was to save 6%…

The example is only for someone making $50,000 a year.  I make more (or less) than that, what percent should I be saving?  For our purposes, the annual income is irrelevant because everything can be depicted in percent of income.  The actual amount of your current income does not matter when figuring out what percentage of income to save.  If you make $100,000 dollars a year, you will have a higher standard of living in retirement ($85,000 a year) but by saving 20% of $100,000 you’ll be saving enough money to account for the higher standard of living.  The only thing that changes when you make more money, is that your expected benefit from Social Security decreases (as a percentage of income).  Here is a chart explaining this (All data is from SSA.gov).

If you make $50,000 a year and retired today, social security would pay you about 37% of your current income.  If you make $100,000 and retired today, social security would only pay you about 26% of your current income.  The take away here is this:  if you assume that you will only get 10% of your income in social security benefits, then at $50,000 a year that represents a much larger cut from current benefits than at $100,000 a year.  If you don’t assume any social security benefits, then your current income has absolutely no affect on the  “Percent of Annual Income Needed to be Saved” chart.

1. Individual Stocks and Retirement Portfolios

This is part one of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for the introduction.

Should I own individual stocks in my retirement account?  In the Fall of 2007, I had just come off a bitterly disappointing fantasy baseball season.  It was a season where I spent about 30 minutes a day researching stats and adjusting my roster.  Every day I would look at each player to see what his batting average was against the opposing pitcher, if he was on a hot streak and or even if he was playing a day game or night game (some players hit better in the day).  So when I came in third place, I felt like I had nothing to show for all the time and research that I had spent that season.

Coincidentally, that semester in school I was introduced to the stock market for the first time and became fascinated with the idea of making money in stocks.  I thought to myself, “If I spend as much time as I do on fantasy baseball on researching stocks, I might be able to actually make money instead of wasting my time looking at baseball stats.”  And so I began investing in a discretionary (non-retirement) portfolio.

As of today, my portfolio’s value has declined about 4 percent from its original value in 2008.  This is not terrible considering many portfolios lost 1/3 of their value during the mortgage crisis that happened to occur at the same time, but it is also nothing to brag about.  I still keep some money in this discretionary portfolio, but when I asked myself the question “Where should I put my retirement money?” I vowed to never own any individual stocks in my retirement portfolio.  Here are the three questions I asked myself that got me to that conclusion.

How much time do I want to spend on my retirement account every week?  Believe it or not one of the best books I read on individual stock investing was Real Money by Jim Cramer.  It was great at teaching the basics of how to analyze stocks and time the market by explaining things like price to earnings ratios and sector rotation.  One of the most important lessons I learned from Cramer was that owning stocks was not about “buy and hold” but “buy and homework” – as he is famous for saying.  He recommends that you do one hour of research per week for every stock you own, and that you need to own at least 5 stocks to have a diversified portfolio.  That is five hours more than I want to spend thinking about my retirement account every week.

If I spend the time, will it be enjoyable or stressful?  All right, let’s say I did have the time and inclination to spend at least 5 hours a week doing research.  That means that I’d be checking my stocks’ value once a day on the internet.  I would be straining my ear if I heard something on the radio about the stock market and thinking of what it might mean for my retirement.  Instead of flipping channels right past CNN I might actually want to hear what the talking heads are saying about the Federal Reserve and interest rates – and still have no idea if I should buy or sell some of my shares.  I know for a fact that there will be surges of joy when my portfolio goes up 2% in value one day, and then instant depression if the portfolio’s value drops. To me it just sounds like stress.  Especially when my ability to retire is on the line.

How likely am I to get better returns than everyone else?  Just for fun, I asked myself, what if I did have the time, and I didn’t mind the stress.  What makes me think – as an individual investor researching 5 hours a week – that I am going to see greater returns than a MBA that does this for a living?   Sure, there are always going to be a few people that made the right call and hit it big.  And I will always have some friends telling me how good the market’s been to them (though I know they are probably lying).  The fact of the matter is that the market is a zero sum game.  The winners and losers must balance out.  How can I be so sure that I’ll be on the winning side?  As I later learned (and present in part 2), all the research indicates that underperformance is a much more likely scenario.

I’m not trying to say that investing in individual stocks is always a bad idea.  I am saying it’s a bad idea for a retirement portfolio.  Its one thing if you make the wrong call in your discretionary portfolio and have to buy a 40 inch TV instead of the 60 inch 3D HDTV you’ve been saving for.   But what if you make the wrong call in your retirement portfolio?  The fact is, because the retirement nest egg is so important to your future security, buying and selling decisions have extra stress and extra importance.   Having that extra stress for returns that aren’t even likely to beat the market hardly seemed worth it.  Especially when I have to spend at least 5 hours a week.  So If I don’t want to invest in individual stocks myself, where should I put my money?

To continue reading, follow the link to Part 2 – The Case for Index Investing.

2. The Case Against Mutual Funds

This is part two of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part one.

I knew I did not want to invest in individual stocks myself, but I still thought that  picking the right stocks at the right time was the only way my retirement portfolio was going to grow.   Personally, I was not confident that I would find an edge over other investors or even that I would be able to overcome the human tendency to want to sell low and buy high – the opposite of good trading.  But I figured some savvy broker with a Harvard MBA would be able to.  As a result I started looking into actively managed mutual funds.  Mutual funds are an investment vehicle that pools money from individual investors and leaves it in the hands of the fund manager (the savvy MBA type).  This fund manager’s only job is to make money for the investors in this fund.  Usually he or she (most likely a he) will have a team of research assistants and all day they research stocks, bonds, commodities… you name it.  If he has 3 assistants, that means the fund spends an average of 160 hours a week researching the market (compared to the 5 that I would devote to it).  And that’s if they only work 8 hour days.  In other words, mutual funds have the time and experience to make better investing decisions – and get better returns.  Or so I thought.

It turns out that buying mutual funds – a retirement solution that so many people rely on, is one of the worst investment vehicles for your retirement money.  That is in part due to the fees and commissions that are associated with buying some funds (such as loads), but most importantly it is due to mutual funds under-performance relative to the market.  The biggest fallacy in the finance industry today is notion that actively managed funds will outperform the market.

What is “the Market?” When I say that most mutual funds fail to beat the market, what do I mean by “the market?”  The market is an elusive term, but most often refers to the return you would get if you literally bought every stock listed on the S&P 500.  The  S&P 500 is an index made up of 500 stocks selected by Standard and Poors (S&P) to be an indicator of total US Stock performance.  There are many other indexes designed to track the market performance – you’ve probably heard “The Dow” (Dow Jones Industrial) or “The Nasdaq”  or even the Rusell 3000 quoted on news stations. They all represent different ways of measuring the market’s overall performance. The Russell 3000, for instance, is an index composed of the 3,000 largest US traded stocks.  While all of the indexes mentioned above track essentially the same thing, the S&P 500 is often used as the standard benchmark for the performance of US stocks.

There is a lot of debate over what exactly is the average return you can expect from the market over a long period.  But for this post, the exact return that you can expect is irrelevant since the market, over the long term, has proven to be the best type investment that you can make.  The market consistently outperforms other investments such as bonds and treasury bills.  If you interested in the types of annual returns you could expect for each investment type or are skeptical about my claim tat the market is the best investment, see the post on “Average Annual Market Returns.”

Nowadays buying the market is possible because of index funds.  An index fund is a type of mutual fund or ETF (Exchange Traded Funds – more on that in Part 3) that has a portfolio meant to exactly track a market index.  For example, there is a S&P 500 index fund.  That means when you buy this fund, its performance will exactly match the performance of the S&P 500, which will come pretty close to matching the entire performance of the US stock market.  Index funds are considered a form of passive investing (as opposed to active investing) because the managers of index funds make no attempt to make money.  The managers (probably just a computer program) simply aim to make sure the fund’s portfolio matches whatever index it is tracking.

Because of the existence of index funds, achieving the same return as the market takes absolutely no skill whatsoever – since everyone can do it.  As a result, the market returns have become the standard by which all active investing strategies and managers are measured.  In other words, if you are a mutual fund manager and you buy and sell individual stocks all year, yet at the end you have under performed the market, you will look silly.  You could have bought an index fund and sat back in your big comfy leather chair, done absolutely nothing, and would have generated better returns.

Are Mutual Funds really that bad? If you are like me, you would expect that mutual funds would consistently beat the market, but it turns out that they don’t.  One of the best books I read exposing this truth was The Power of Passive Investing, by Richard Ferri. A main point that the book constantly drums into your head is that 2/3 of mutual funds fail to beat the market. Further more, the average underperformance from losing funds was more than double the outperformance of winning funds.  I’ve stated it as simply as I can here. But let me assure you, there is an entire book full of independent studies to back this up. The image below is one of the most straightforward pieces of evidence in the book.  It shows the performance of the 136 actively managed funds (that invested primarily in domestic equity and have been around for the past 25 years) compared to the S&P 500 index fund.  There is no secret to the numbers, you can find the annual returns for each of these funds online.


Providing evidence of mutual funds underperformance is more than just one man’s crusade.  Even the popular investing site, The Motley Fool agrees, stating that “more than 80% of  mutual funds underperform the stock market’s average returns.”

Why haven’t I heard this before? I know what you are thinking – “If this is true, then why haven’t I heard this before and why don’t more people know about it?”  I thought the same thing.  According to Ferri, the primary reason we flock to mutual funds is because of the massive amount of advertising that is done on their behalf.  You see commercials for financial advisors and mutual funds, but you don’t see commercials for index funds. Most investment companies earn revenue by selling investment products and charging commissions or fees – two things you can’t charge an investor who simply buys index funds. Simply put, its hard to make money off of index funds, so the investment companies wont promote them.  Mutual funds on the other hand, are a cash cow for many companies.

But if the numbers are so terrible, how do they make mutual funds look so good in advertisments?  First, they only tell you the mutual fund return independent of the fees and commissions you will have to pay (Average mutual fund fees can reduce your annual return by 2%!)  What’s more is that advertisements only talk about the winning funds (which as shown above, actually represent the minority of funds).  How many times have you heard about Fidelity’s Magellan fund?  When I think of mutual funds, that’s what I think of, and it was one of the best performing funds of our time – consistently outperforming the market.  Is it really that surprising that you’ve never heard marketing for a fund that underperforms?

There are also a bunch of other tricks that advertisers use. They might compare their mutual fund’s performance to inappropriate benchmarks.  An example might be a mutual fund that had a majority of its holdings in domestic stocks, but had 40% in emerging market funds.  If emerging markets generated great returns and you compared that fund to the S&P 500 (a domestic stock index) it might look like you “beat the market,” when perhaps your emerging market stocks didn’t even beat the emerging market fund index.  Another strategy for advertisers is to give you the line, “why would you want to subject your self to merely average returns when you could have better than average returns?”  And they have a point.  Investing in an index fund guarantees you will get average returns, and investing in a mutual fund could get you better returns.  What they leave out is that getting better returns is not that likely.

Though I was initially skeptical that mutual funds could be that bad, I ultimately couldn’t ignore the data from multiple sources that said the same thing.  Two thirds of mutual funds fail to beat the market.  So if you can’t beat the market with a mutual fund, then why not just buy the market?

To continue reading, follow the link to Part 3 – Asset Allocation.

3. Asset Allocation

This is part three of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part two.

At this point I was feeling pretty good.  I had just discovered an irrefutable truth about investing that not many people knew –  and it was actually going to make me money.  I was going to buy an index fund instead of a mutual fund and ride the market’s performance all the way until retirement.    Except its not quite that easy, because you can’t just buy one index fund.  One of the main points that was pounded in my head through all my research was that you can’t have have all of your retirement money in stocks.  In order to have a safe retirement portfolio, you must have your money in more than just one asset class.  An asset class is a group of securities (things you can buy on an exchange) with similar risk and rate of return characteristics.  For example, investors often refer to stocks, bonds and cash equivalents as the three main asset classes (some might also include Real Estate and Commodities).   Stocks have the highest risk and the highest return, cash equivalents are the lowest risk, but also have the lowest returns.  Bonds are somewhere in the middle.   The main reason to have different assets is to reduce the risk of your portfolio.  If you have a portfolio of all stocks, and the market crashes, you are out of luck.  But if the market crashes and you own bonds as well, your portfolio won’t lose as much value.  That is the very basic explanation of asset allocation.  Another benefit to having different asset classes (also known as diversifying your portfolio) is that when you rebalance your portfolio, you are guaranteeing that you are selling high and buying low.  More on that in Part 6.

How should I divide up my retirement money? As a young investor, the conventional wisdom says that you want 80-90% of your retirement money in stocks and the rest in bonds.  As you get closer to retirement you will want more money in bonds and in cash (the safer investments) so that you can preserve the money you saved.  There is a whole science out there about the best way to allocate your assets which I am only skimming the surface of.  In fact, most of the experts have a much more nuanced view of asset allocation.  It is not just about stocks and bonds, but about certain categories of stocks and certain kinds of bonds.   Richard Ferri’s book, The ETF Book, recommends the following asset allocation for “early savers.”

  • 25% – Total US Stock Market
  • 15% – Small Cap Value Stocks
  • 5% – Micro-Cap Stocks
  • 10% – Real Estate
  • 10% – Pacific Rim Stocks
  • 10% – European Stocks
  • 5% – Emerging Market Stocks
  • 10% – Total US Bond Market
  • 5% – Inflation Protected Bonds
  • 5% – High-Yield Corporate Bonds

That is 10 different asset categories!  More generally, however, it is 80% stocks (55% US, 25% International) and 20% Bonds.  Compare that allocation to Ferri’s suggestions for those who are about to retire.  The generalized allocation is 50% stocks (35% US, 15% International), 45% Bonds and 5% Cash:

  • 23% – Total US Stock Market
  • 7% – Small Cap Value Stocks
  • 0% – Micro-Cap Stocks
  • 5% – Real Estate
  • 6% – Pacific Rim Stocks
  • 6% – European Stocks
  • 3% – Emerging Market Stocks
  • 30% – Total US Bond Market
  • 10% – Inflation Protected Bonds
  • 5% – High-Yield Corporate Bonds
  • 5% – Cash

Can I find a fund for each of these asset categories? When I first looked at this list, I thought it would be impossible to find funds for some of the more interesting categories like “Inflation Protected Bonds.”  Fortunately for us, you can buy an index fund for every one of these asset classes.  It didn’t always used to be this way.  In fact, it wasn’t until 1975 that the first index fund was created by Vanguard as a mutual fund.  And it wasn’t until 1993 and the creation of ETF’s that enabled  you to buy an index just like you would buy a stock. Check out the link for more information of how ETFs work.  Personally, I like to think of ETFs as mutual funds but with ticker symbols.

You’ll notice that index funds can be both mutual funds and ETFs.  There is a great article by the Motley Fool explaining the differences in detail.  While they perform the same function and will generate the same returns (not accounting for any fees), there are differences in their underlying mechanics and the ways in which you can buy mutual funds and ETFs.  With mutual funds, you buy your shares at the end of every day.  There also may be a minimum amount you must invest to enter the fund.  With ETFs you buy a share of the index fund just like you would buy a stock.  For example, to buy the Ishares (a brand) S&P 500 index fund, you would search for ticker symbol “IVV” and place an order, which would be subject to any commissions that you get charged for trading stocks.  Most of the index funds out there today are ETFs and because they have ticker symbols they are often more easily bought and sold than mutual funds that you may only be able to buy if you have a certain company’s brokerage account.

It is important to note that not all index funds are benchmark indexes – or indexes that are meant to track the performance of a market.  Generally, when speaking about index funds – as I have in previous sections – investors are referring to benchmark indexes.  Strategy indexes are index funds that use analysis or strategy to pick stocks in their index and are not meant to track the market.  For example, there could be a strategy index ETF that uses a screen so that only stocks of socially responsible companies are in the index.  Another strategy index may use a complex mathematical formula to constantly buy stocks that exhibit certain price trend characteristics.

Strategy index ETFs like these outnumber benchmark indexes by 2 to 1 in ETF market (according to Ferri’s The ETF Book), but from my point of view they are not something that you want in your retirement portfolio.  Because strategy indexes are attempts to beat the market, they should be treated the same way as actively managed mutual funds and should have their performance compared to the market’s performance.  While there have been no studies (that I have seen) measuring performance of strategy indexes against the market, I am willing to bet that their performance is about the same as mutual fund performances – which as you will recall from part 2, is not very good. Furthermore, if you agree that having proper asset allocation in your retirement portfolio is important, then strategy index funds will not work for you.  It will be impossible to tell if your strategy index (that is based on some computer model with stocks that change every day) will have the proper ratio of micro cap to small cap to emerging market stocks.

How do I actually buy these different asset categories? At this point, I knew I didn’t have all the specifics, but I had a general plan for how I was going to actually fund my retirement account.  As I saw it, the first step was to find an ETF benchmark index that matches the asset categories I was looking for.  Once I found an ETF for each of the 10 categories listed above (for a young investor), I would buy each of the 10 ETFs every time I put money into my retirement portfolio.  I would make sure that the amount of money I had in each ETF was equal to the percent that recommended in the preffered asset allocation.  Lets say each ETF cost $1 a share (in reality the Bond Index ETF might cost $21.63 a share and the Emerging market Stock Index might cost $84.16 a share) and I had $100 to put in my retirement portfolio.  I would buy 25 shares of the Total Stock Market ETF, 15 Shares of the Small Cap Stock ETF, 5 shares of the Micro Cap stock index and so on…  In a case where all the shares were $1, except for the Total Stock Market ETF which was $25, I would buy just 1 share of the Total Stock Market ETF.  Its not the number of shares that count, but the amount of money in each category.

My retirement plan was finally starting to come together – that was until I realized that there was more than 1 ETF for every index I was looking for.

To continue reading, follow the link to Part 4 – Expense Ratios.

4. Expense Ratios

This is part four of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part three.

As I began google searching for the first ETF I would buy, I quickly realized that there was more than one ETF for each type of index fund that I was looking for. In fact, for most of the index funds, there were at least three ETFs I could choose from. From my research, it appears that there are three main players in the ETF benchmark index world: Vanguard, Schwab, and iShares. These are three companies that actually “make” their own ETFs. Take the Total Stock Market Index, for example. I saw at the very least that I could buy Vanguard’s ETF (VTI), Schwab’s ETF (SCHB), or iShares’ ETF (IWV). Each of the ETFs were created for the same purpose – to track the performance of the broad (as in not just large companies) US stock market. Each ETF used a slightly different benchmark to track the broad market. IWV uses the Russel 3000 index, SCHB uses the 2,500 stock Dow Jones US Broad Stock Market Index, and VTI uses the MSCI US Broad Market index.  Despite the small differences, each index would be acceptable to use for the 25% of my portfolio that was to track the “Total US Market.” Knowing that each of the three ETFs were essentially the same, I was left with one question:

How do I know which ETF to choose? Since I had at least 3 options in front of me, I had to find a reason to choose one over the other. and I didn’t want that to be based on something silly – like which fund had the coolest ticker symbol. This is where expense ratios come in. Expense ratios are the amount by which your annual return will be decreased as a result of fees from the company that makes your index fund. So for example, IWV, the S&P 500 index fund from iShares has an expense ratio of 0.21%. That means if IWV’s annual return is 10%, the actual return reflected in your bank account would be 9.79%.  As of March 2011, these were the expense ratios for each of the three funds mentioned above:

  • Vanguard’s VTI 0.07%
  • Schwab’s SCHB 0.06%
  • iShares’ IWV 0.21%

The expense ratios are not even one whole percent!  The good news is that this is typical for funds that track the major indexes.  ETFs that track more nuanced indexes, like the emerging markets index, have slightly higher expense ratios.  Here are three examples of Emerging Market ETFs:

  • Vanguard’s VWO  0.27%
  • Schwab’s SCHE  0.25%
  • iShares’ EEM  0.69%

Clearly in the two examples above Schwab and Vanguard funds have the lowest expense ratios.  They are in fact almost identical, leading me to question whether the small percentage differences is a valid reason for choosing one fund over the other.

Is one tenth of one percent really that important?  I found a great website that had an article on how expense ratios affect long term performance.  Using the author’s work as a template, I made a spreadsheet of my own so that I could look at the specific examples I started above.  Lets take the first example – the three ETFs measuring the Total US Stock market:

This is a screenshot from the excel file I was using.  Here I am assuming that each fund will return 8% each year after an initial $10,000 investment.  After 10 years, if you put your money into SCHB which has an an effective annual return of 7.96% (8.0% – .06% expense ratio) you would have $120 less than you would have if you did not have to pay an expense ratio.  After 30 years, you would have $1,664 less in your retirement account because of SCHB’s expense ratio.    Lets say you chose to go with VTI over SCHB.  Over 10 years that choice would have cost you $20 ($140 – $120), and over 30 years that choice would have cost you $274 ($1,938-$1,664).  Now in the grand scheme of things, this is not a whole lot of money, especially over 30 years.  Now if you chose  the iShares IWV fund, I really can’t defend that decision.  After just 10 years you would be giving up $296, and after 30 years you would be giving up $4,043!  This is all money that you could have saved if you chose the SCHB fund.

With such low expense ratios – less than .1% –  the difference between competing ETFs is not as noticeable.  If we take a look at the Emerging Market ETFs, however, the differences become even more real:

In this case, choosing the Vanguard fund over the Schwab fund will cost you $39 in 10 years and $522 in 30 years.  Don’t even get me started on what you would loose if you chose the iShares fund.  That decision would cost you over $10,000 ($17,602 – $6,758) in 30 years!  If you are like me, you might be thinking “Expense Ratios really suck” and might ask yourself why you are buying funds that have them in the first place.

Do other assets have expense ratios? Any type of investment that requires a pooling together of different individual stocks or commodities is likely to have an expense ratio.  Consider it the price you have to pay to organize a number of different assets into one fund.  So while individual stocks don’t have an expense ratio, they are assets that are not relevant in this discussion since we are interested in index funds for our retirement portfolio.  If the lack of expense ratios in stocks make you want to buy them for your retirement, just think of the percent of your (likely) underperformance relative to the market as your expense ratio for buying individual stocks.

As far as mutual funds go, they have expense ratios and much more.  Typical expense ratios for actively managed mutual funds are around 1.5% according to Fool.com.  Not only do mutual funds have expense ratios, but many of them also have sales charges called loads.  A front-end load, for example, is a fee that takes a percentage of your money (around 5%) the moment you buy the mutual fund.  So if you wanted to put $10,000 into a mutual fund with a 5% front end load, you transfer $10,000 into the fund, but only  $9,500 makes it into your portfolio.  Then, after they are done stealing your money up front, the fund will still have an expense ratio further reducing your return that wouldn’t have beat the market anyway.  Now just in case I haven’t proved my point on how important expense ratios are, I want to include some examples of higher expense ratios, like those you might find in a mutual fund.  I haven’t bothered to calculate what loads do to your real return, but i didn’t see the point. Hopefully this spreadsheet scares you enough to never want to buy a mutual fund with a high expense ratio, much less one that charges load fees.

Armed with a new understanding of how to chose each ETF that I would buy, I quickly selected the 10 ETFs with the lowest expense ratios.  I logged onto to my Scottrade Account (my online broker at the time) to make my first trade when it hit me:  At $7 a trade, I would be spending $70 every time I put money into my retirement account.

To continue reading, follow the link to Part 5 – Account Fees and Commissions.